Is high Investment debt forcing you to live paycheck to paycheck?

Forsaken_GA

MentholMoose wrote: »

Next time you want to make a Roth account look good, you should assume a LOW current tax bracket and a HIGH future tax bracket, not the other way around as you have done here.

Let me get this straight - Are you suggesting that I'm incorrect in saying that when you retire, you'll likely move to a lower tax bracket? Because it sounds like you're saying that you will move to a higher tax bracket.

Here's the way it normally works - You start working, you're in a lower tax bracket. You keep working, you make more, you move to a higher tax bracket. Once you're done working and you retire, you move to a lower tax bracket. So yes, for the majority of people, you will go from a higher tax bracket to a lower tax bracket.

Feel free to offer proof to the contrary if you can.

My impression from the OP is that right now every dollar counts. Saving a few bucks on taxes could help him reach his near-term savings goal.

Ok, your logic breaks down yet again right here.

If every dollar counts, you should not be doing *any* investing. Advising the OP to contribute to a 401k to lower their tax bill to help with their monthly bills is bad advice. If I contribute $1000 to my 401k, sure, I don't pay $250 in taxes that year, but I still don't have my hands on that $1000. If every dollar counts, I shouldn't be contributing that $1000, I should be bringing it home, paying the $250 so that I have now have an additional $750 to use to pay towards my bills. Losing the liquidity of $1000 in order to avoid paying $250 in taxes does *not* help you if every dollar counts. It could potentially harm you as well, since if you need to take that $1000 back out in order to survive, not only are you now paying whatever you would have saved in taxes, you're also paying an additional 10% in penalties.

Let me guess, you probably also think it's a good idea to keep a mortgage around for the tax deduction as well, right?

I think the key point you're missing is that your earnings both grow 'tax-free', in the sense that you're not paying capital gains on your earnings, like you would with a non tax-advantaged investment account. That much is true for a Roth and a 401k. The difference is that your earnings on a 401k are not entirely tax free - you *will* pay taxes on your earnings when you withdraw them from your 401k, it'll be your ordinary income tax rate.

With a Roth, your earnings are truly tax free. When you withdraw earnings from your Roth account, you keep all that money. That is where the advantage of a Roth is realized over a 401k (and why the Roth has a very small yearly contribution limit). If you make enough money to do both, you should be doing both, but if the amount you have to invest is small enough to make a choice, the priorities are simple -

#1 401k up to what your employer matches. The free money from the match outperforms all other investment options. The government still gets a huge chunk, but your bottom line is less effected because the gains made on the employers contribution offsets the other monetary disadvantages of the 401k.

#2 Roth IRA up to the $5,000/yr limit - You only pay taxes on your contributions, and every single cent of your earnings grows tax free. This is the single best investment option where only *your* cash is involved.

#3 Anything additional you have to invest, should be invested back into your 401k above the employers match, up to it's contribution limit.

If you make enough that even after doing all three of those, you still have money left to invest, you have enough money to pay for professional tax advice and should not be taking advice from an internet forum

MentholMoose

Sorry for the late reply, I was working on this yesterday and got busy with something else.

Forsaken_GA wrote: »

With a regular 401k, the only thing you're doing is pushing off your tax payment. Your contributions and it's earnings are taxed at your ordinary income rate when withdrawn, which tends to be less when you've retired. That's how they get you, it sounds like a good idea...

Maybe I haven't explained things clearly so I'll just quote Roth IRA - Wikipedia, the free encyclopedia. From Advantages:

If the Roth IRA owner expects that the tax rate applicable to withdrawals from a traditional IRA in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions before retirement, then there may be a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle while working. There is no current tax deduction, but money going into the Roth IRA is taxed at the taxpayer's current marginal tax rate, and will not be taxed at the expected higher future effective tax rate when it comes out of the Roth IRA.

From Disadvantages:

A taxpayer who chooses to make a Roth IRA contribution (instead of a traditional IRA contribution or tax deductible retirement account contribution) while in a moderate or high tax bracket will likely pay more income taxes on the earnings used to make the Roth IRA contribution as compared to the income taxes that would have been due to be paid on the funds that would have been later withdrawn from the traditional IRA, had the taxpayer made a traditional IRA contribution. This is because contributions to traditional IRAs or employer sponsored tax deductible retirement plans result in an immediate tax savings equal to the taxpayer's current marginal tax bracket multiplied by the amount of the contribution. It has been shown that many people have a lower income in retirement than during their working years, and thus end up in a lower tax bracket in retirement, and this is another reason why withdrawals from a traditional IRA or tax deferred retirement plan in retirement are likely to result in a lower tax bill. The higher the taxpayer's marginal tax rate, the greater the disadvantage.

That is what I was trying (and apparently failing ) to communicate. To summarize, all else equal:

• Expect your tax bracket during retirement to increase from the present - Roth account has an advantage.
• Expect your tax bracket during retirement to not change from the present - This factor is nulled out.
• Expect your tax bracket during retirement to decrease from the present - Roth account has a disadvantage.

There are other pros and cons so I recommend considering what is and isn't applicable to your situation before deciding. I raised this particular point because from what I could tell, you were trying to demonstrate in your example that a Roth account has a tax advantage over traditional accounts when expecting a lower tax bracket during retirement than at present, which is demonstrably false.

Forsaken_GA wrote: »

Let me get this straight - Are you suggesting that I'm incorrect in saying that when you retire, you'll likely move to a lower tax bracket? Because it sounds like you're saying that you will move to a higher tax bracket.

Here's the way it normally works - You start working, you're in a lower tax bracket. You keep working, you make more, you move to a higher tax bracket. Once you're done working and you retire, you move to a lower tax bracket. So yes, for the majority of people, you will go from a higher tax bracket to a lower tax bracket.

I don't disagree with that except that it may be an over-generalization. What matters when deciding what to contribute to is the tax bracket at present and how that relates to what it will be at retirement. Someone early in their career may be in a low tax bracket that may be lower than their tax bracket during retirement. After reaching a certain point, though, they will be in a higher tax bracket, which may be higher than it will be during retirement. Therefore, you may need to adjust your investments accordingly depending on where you are in order to maximize your net income at retirement. There seems to be resources online, a quick search came up with this article which has a few considerations: Why You’re Likely To Be In A Higher Tax Bracket When You Retire - Saving Advice.

Forsaken_GA wrote: »

If you're still going to insist that 401k's grow tax free, I'm going to have to insist on some proof, because I can drown you with a bunch of links that demonstrate quite clearly the opposite.

As I said in the text you quoted, the distributions from a traditional 401(k) / IRA are taxed. However, you don't pay tax until you take distributions, correct? Or in other words, it's tax-free until the distribution, i.e. tax-deferred. Sorry for not explaining it clearly enough.

Forsaken_GA wrote: »

I'm going to ignore the rest of your math, since it's based on the assumption that 401k's grow tax free, which makes everything you've said incorrect. Obviously if you're comparing a lesser investment to a greater one, the numbers are going to be different, it's apples to oranges. In order to contribute $1000 to a Roth IRA, yes, you're eating the taxes on that $1000 for that year.

As I've already mentioned, if you actually deposit $1,000 in a Roth account, you need more than $1,000, specifically you need $1,333: 25% ($333) to tax, $1,000 to the Roth account. If instead you chose a traditional account, you could contribute that entire $1,333. A valid comparison must include the actual cost of the investment... so, compare a $1,000 investment in a Roth account with a $1,333 investment in a 401(k) or traditional IRA (or $750 versus $1,000, respectively). This is frequently ignored and people simply compare what happens to the $1,000 once deposited into a Roth account versus $1,000 into a traditional IRA or 401(k). Ignoring critical information such as what you actually spent on the investment affects the outcome and makes your comparison apples to oranges.

I don't know how to make this more obvious. I guess just imagine you want to buy one share of Google stock. Broker A charges a fee of $100, Broker B charges $10. Regardless of which broker you use, you end up with one share of Google stock ($539 at today's price). Should you only look at that $539? Absolutely not. With retirement it is more complicated because of the taxes, but the point is simply that you cannot ignore the actual cost of an investment.

Forsaken_GA wrote: »

The difference in my example is that I can either pay $250 bucks the year I make the $1000 investment, or I can pay $18k when I cash out. I'll pay the $250, thanks.

By that logic, where do you draw the line? What if you could pay $250 now or $251 when you cash out? $250<$251 so would you choose $250? The problem with this line of reasoning is that it ignores the time value of money. Obviously, from your example, $250 is less than $17,797, but that is $250 of dollars today versus $17,797 in 40 years. That is apples to oranges.

To compare different values at different times, use Present value. I don't know of an online PV calculator that allows using a monthly interest rate as in your example, so just modify the equation...
PV = $17,797/((1+0.01)^480) = $150

Based on the assumptions in your example, that $17,797 in 40 years is equivalent to $150 in current dollars, and (all else equal), paying $250 instead of (the equivalent of) $150 is not a rational decision. Check out Time value of money for more info, it will help with understanding this concept.

I'll work through and expand on the original example as clearly as possible in case it's still not clear.

You have $1,000 of pre-tax income to put into a retirement account for 40 years, expect a 12% rate of return compounded monthly, have a marginal tax rate of 25% at present and expect that to decrease to 15% at retirement. What do you do?
a)
1. Pay 25% tax ($250) on your $1,000 pre-tax income.
2. Put the $750 of remaining (post-tax) income into a Roth account.
3. It grows to $88,986.
4. Distributions are not taxed.
5. End result: $88,986
b)
1. Pay 0% tax ($0) on your $1,000 pre-tax income.
2. Put the entire $1,000 into a traditional 401(k) / IRA.
3. It grows to $118,648.
4. You pay 15% tax ($17,797) on distributions.
5. End result: $100,851

By going with b) you end up with $11,865 more than a). As explained above, based on this particular criteria, if your tax bracket in retirement will decrease from present, a Roth account is at a disadvantage and you may be better off contributing to a traditional IRA / 401(k) as this example shows.

Now, change the example to assume a future tax rate unchanged from present to 25%. a) remains unchanged, but for b) you pay 25% ($29,662) tax on $118,648, so the end result is $88,986... the same as a).

Now, change the example to assume a future tax rate increase from present to 35%. a) remains unchanged, but for b) you pay 35% ($41,527) tax on $118,648, so the end result is $77,121... now a) is better for this particular criteria.

Forsaken_GA wrote: »

If every dollar counts, you should not be doing *any* investing. Advising the OP to contribute to a 401k to lower their tax bill to help with their monthly bills is bad advice.

My understanding is that he is having trouble with putting some retirement savings together, not with putting food on the table. If the options are food or 401(k) contributions I don't think anyone would recommended starving to death (for the record, in that situation I advise buying food).

Forsaken_GA wrote: »

#1 401k up to what your employer matches. The free money from the match outperforms all other investment options. The government still gets a huge chunk, but your bottom line is less effected because the gains made on the employers contribution offsets the other monetary disadvantages of the 401k.

#2 Roth IRA up to the $5,000/yr limit - You only pay taxes on your contributions, and every single cent of your earnings grows tax free. This is the single best investment option where only *your* cash is involved.

#3 Anything additional you have to invest, should be invested back into your 401k above the employers match, up to it's contribution limit.

I agree with #1 and said as much in my first post. For #2 I agree, if he can do it, based on the assumption he is in a relatively lower tax bracket and his retirement tax bracket will be higher than his present tax bracket. If he can't quite get the $500 of post-tax income for a Roth account (similar to how he can't quite get $500 of post-tax income for a CD), and definitely wants to contribute to some kind of savings, then he can consider using pre-tax income to fund a traditional IRA, or to make additional 401(k) contributions (i.e. #3). I only said in my first post that this was an "option" that he can consider, along with additional contributions to his 401(k).

Forsaken_GA

MentholMoose wrote: »

Maybe I haven't explained things clearly so I'll just quote Roth IRA - Wikipedia, the free encyclopedia. From Advantages:

I'll respond to the rest of this later (it'll take awhile), but before I do, I'll point out you're breaking the cardinal rule of Wikipedia - First place to look, last place to source

michaelcox

mog27 wrote: »

Still much prefer Suze's philosophy over Dave's. But, hey, whatever works for your particular situation.

I think the biggest thing that they are both recommending is to just get some money in the bank that you don't touch. For too many years, the US has had a negative savings rate. So, start saving some money. Then pay off debt. Then save a bunch more money.

Claymoore

I disagree with paying the smallest balance first. I hate paying interest so I will pay off the highest interest rate first, then snowballing that payment to the next lowest interest rate. I saw a calculation once that shows you may make payments longer, but you will pay less interest and thus less money overall. Thus my wife's student loan - easily the largest balance - will be the last one paid since it has the lowest interest rate.

michaelcox

Claymoore wrote: »

I disagree with paying the smallest balance first. I hate paying interest so I will pay off the highest interest rate first, then snowballing that payment to the next lowest interest rate. I saw a calculation once that shows you may make payments longer, but you will pay less interest and thus less money overall. Thus my wife's student loan - easily the largest balance - will be the last one paid since it has the lowest interest rate.

that of course is true and Dave Ramsey acknowledges that. The reason he recommends paying them off smallest to largest though is the sense of accomplishment that you get by completing it. If your smallest bill is $2,000.00 but is also your smallest interest rate (say 4%), but your highest interest rate (say 10%) has a balance of $200,000.00, there will be a long time before you get the sense of accomplishment and, human nature as it is, will often times cause us to give us.

MentholMoose

Forsaken_GA wrote: »

I'll respond to the rest of this later (it'll take awhile), but before I do, I'll point out you're breaking the cardinal rule of Wikipedia - First place to look, last place to source

I only quoted that particular text since it matches my understanding. I did not use Wikipedia for research. If you need different sources explaining this point, here you go.

http://www.totalmerrill.com/publish/mkt/pdfs/FiINAL%20Roth%20White%20Paper%20November.pdf

As previously noted, income tax rates may be higher in the future than they are today if (a) the government increases income tax rates or (b) an individual’s income increases, resulting in a higher tax bracket. Therefore, tax rates now, as well as tax rates when distributions from the Roth IRA will occur, must be taken into consideration to determine whether or not conversion makes sense. Investors may potentially lock in to a lower tax rate if they feel they are going to be in a higher tax bracket during retirement or that tax rates overall are going to increase. If a lower tax bracket is anticipated when distributions from the Roth IRA will occur (most likely during the retirement years), paying income tax now on the converted funds at the present (and higher) income tax rate may not be very appealing. Individuals can pay taxes on a smaller appreciated asset base so any future appreciation has the opportunity to grow tax-free, thus creating a larger asset pool to help fund retirement. However, if a higher tax bracket is anticipated when distributions from the Roth IRA will occur, converting the assets to a Roth IRA now and paying tax at the present (and potentially lower) income tax rate may be advantageous.

http://www.vanguard.com/pdf/rpd21.pdf

From a mathematical standpoint, the decision of which type of IRA is more beneficial for a particular investor is primarily dependent on the investor’s expectation of their future tax rate relative to their current tax rate. The tax rate assumption is important because the after-tax dollars are equivalent whether the investor puts pre-tax dollars in a tax-deferred plan or after-tax dollars in a tax-free plan (assuming identical investment amounts and rates of return). It is generally preferable for an investor who expects to be in a higher tax bracket, or believes that significant tax hikes could be on the horizon, to consider converting to a Roth IRA and paying taxes on the conversion at the current, presumably lower tax rate.

The Simple Tax Math Of Roth Conversions

In fact, tax neutrality helps to focus your IRA decision on the one critical variable that is likely to change in the future: the effective marginal income tax rate that you pay.

• If this rate is the same in the future as today, tax-neutrality prevails.
• If this rate increases in the future compared to today, a Roth conversion prevails.
• If this rate decreases in the future, a Traditional IRA prevails.

Roth 401k vs. Traditional 401k: Which Is Best for You? - CBS MoneyWatch.com

• If you’re in the same marginal income tax bracket now and in retirement, there’s no difference in the after-tax amount you have to spend in your retirement between a traditional and Roth 401k.
• If you’re in a higher tax bracket in retirement compared to now, you’ll have more money to spend in retirement if you contribute to a Roth 401k.
• If you’re in a lower tax bracket in retirement compared to now, you’ll have more money to spend in retirement if you contribute to a traditional 401k.

My Financial Awareness -401(k) & IRA

As you can see each vehicle while end up with the same amount at age 65 ($40,454) under a constant tax rate. One may wonder how this can be when the tax for the Roth IRA was only $1,500 ($5,000 x .30 tax rate) while the 401(k) and IRA the tax is $17,337 ($57,791 x .30 tax rate). This is because the government will take 30% of the money either at the beginning or at the end. Now, imagine your money as a pie circle. If the money (pie circle) expands outward at similar rates, the government will take its 30% slice whether it is on the smaller pie or larger pie. In the end, 30% of the pie is still gone due to taxes. Thus, in an IRA, Roth IRA or 401(k) plan, your share is the remaining 70%.

I have no interest in debating the relative merits of Roth versus traditional IRAs so if that's your plan just save your time and suggest links and resources for the benefit of others. There are pros and cons for each as I've said already. I brought up this particular point because you used bad math to come up with a incorrect conclusion.

Turgon

MentholMoose wrote: »

I only quoted that particular text since it matches my understanding. I did not use Wikipedia for research. If you need different sources explaining this point, here you go.

http://www.totalmerrill.com/publish/mkt/pdfs/FiINAL%20Roth%20White%20Paper%20November.pdf
http://www.vanguard.com/pdf/rpd21.pdf
The Simple Tax Math Of Roth Conversions
Roth 401k vs. Traditional 401k: Which Is Best for You? - CBS MoneyWatch.com
My Financial Awareness -401(k) & IRA
I have no interest in debating the relative merits of Roth versus traditional IRAs so if that's your plan just save your time and suggest links and resources for the benefit of others. There are pros and cons for each as I've said already. I brought up this particular point because you used bad math to come up with a incorrect conclusion.

Thanks for taking the time out to post these references. Interesting debate.